John Mills
Economist, entrepreneur and the Chairman and majority shareholder of JML

THE BLOG

Debunking the Myths Surrounding Exchange Rate Realignments

277

15/07/2014 16:41 BST
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Updated
14/09/2014 10:59 BST

The UK is in trouble. It cannot pay its way in the world. We charge too much for our exports and we import far too much. Too few people buy British-made goods, because they are too expensive. We have high unemployment, high rates of inequality and the UK is falling deeper and deeper in debt.

The only policy which will remedy these problems is to get the UK cost base down to a level which will make it possible for us to re-establish enough manufacturing capacity to enable us to compete in the world. To do this, some fairly simple calculations show that we need to get the pound down by about a third from where it is now - to around $1.05 or €0.80.

Why don't we do it? There are two main reasons why this is not currently on many people's policy agenda. One is fear that such a policy would not work. The other is that for almost all the last century and a half British exchange rate policy has been broadly orientated to keeping sterling as high as possible and it would be a wrenching change to move to a different strategy. A big part of the reason why this change is difficult is a series of misapprehensions, or myths, the key ones being:

If you reduce the exchange rate you get high inflation

It is widely believed that lowering the exchange rate produces more inflation than would have occurred anyway. This simply is not true, as can easily be seen by looking at historical statistics. It did not happen, for example, when we left the Exchange Rate Mechanism in 1992. Inflation fell from 5.9% in 1991 to 3.7% in 1992 and to 1.6% in 1993 before stabilising for the next few years at about 3%.

Living standards are reduced

It is not true that having a lower pound reduces living standards. If the growth rate increases, the average standard of living must go up. Again 1992 provides a typical example. Allowing for population growth, GDP per head rose 0.3% in 1990, fell 2.0% in 1991 and was static in 1992 before growing by 2.0% in 1993 and 4.0% in 1994. It seems counter-intuitive that reducing the value of the pound on the foreign exchanges would make everyone in the UK better off on average - but this is what would happen.

The government cannot change the exchange rate

It is also not true that governments cannot change the exchange rate if they want to do so. There are many examples showing that this can be done. The UK government pursued policies which raised it by over 60% between 1977 and 1982. Implementing opposite policies would have the reverse effects. The most conspicuously successful example of this was the 1985 Plaza Accord between the USA and Japan, which reduced the value of the then grossly over-valued valued dollar by 46% against the Japanese Yen.

Other countries would retaliate

It is very unlikely that other countries either would or could retaliate against us. The dollar is a reserve currency. The Eurozone has many other pre-occupations at present. Our share of world trade is now so small that countries such as China would hardly notice the change - as indeed happened between 2007 and 2009, during which the pound dropped from an annual average of $2.00 in 2007 to a low of $1.56 in 2009, before stabilising at $1.60 in 2011.

Exchange rate management doesn't work

It is not true that we have tried to get a lower pound before and found that it does not work. All the major currency reductions which have taken place in the past - 1931, 1949, 1967, 1992 and 2007/09 - were forced upon us by balance of payments crises and in nearly all cases did no more than reduce the pound from being grossly over-valued to being a little less so. The exception was in 1931 when there was a major devaluation - by about 30%. It produced a spurt of growth - at 4.4% cumulatively per annum between 1933 and 1937 - which was the fastest rate of growth the UK economy has ever achieved over a four year period. Unfortunately, towards the end of the 1930s the pound rose strongly against other currencies as the Gold Bloc countries and the USA devalued. Sterling then became as over-valued as it had been before and economic growth declined despite rearmament.

It is true, however, that if the pound went down by a third, imports and foreign holidays would be more expensive. It is also true that all the politicians, civil servants, commentators and academics who have supported policies to keep inflation down as top priority would have to change their mind-set to understanding that getting the exchange rate right is a much more important goal. Changing accepted orthodoxy is likely to be much the biggest obstacle to getting policies for the UK back on track despite the fact that neither the Coalition nor Labour policies for reducing the government deficit will work long term.

Cutting government expenditure will deflate the economy but the consequent falling tax revenue and the mounting cost of unemployment will make the public expenditure gap impossible to close. Reflating the economy with the exchange rate where it is at the moment would be equally self-defeating. It would destabilise the markets and put our credit rating at risk, thus almost certainly raising interest rates and borrowing costs. The reality is that there are no solutions to our current economic problems other than increasing our competitiveness and paying our way in the world.

These solutions will remain out of reach without a competitive pound. Although of course many complementary supply side policies will be needed to take advantage of the opportunities which a much more competitive environment will create. It is all these steps taken together which will allow us to use our labour force to the full, gain a sufficient share of world trade and put us back on the path to prosperity.

Of course, persuading everyone to take a very different view on something as central as economic policy is not easy. The benefits of doing so, however, would be huge. If we really want to tackle successfully many of the economic and social problems which dog our economy at present, there really is no alternative.